Exchange Rate Volatility Tempers Recovery Outlook

Fund managers continue to remain optimistic about stocks, even though potential volatility in the currency markets gives them some pause and a majority of them foresee single-digit returns for the foreseeable future, the most recent Merrill Lynch global fund manager survey shows.

Expecting GDP growth of 4.1% among G7 nations over the next 12 months and undervalued equity prices to rise, fund managers remain upbeat on continued improvement in the markets.

Whereas managers foresaw only a 3.5% increase in GDP growth in July, the 307 fund managers polled in October raised that consensus by 60 basis points. And because they view equities as cheaper than bonds, two-thirds are overweight stocks and, consequently, underweight bonds - the biggest percentage of managers overweighting stocks since Merrill began asking the question four years ago. Just two months ago, only 53% were overweighting equities.

The managers, who collectively oversee $918 billion in assets, see three sectors as showing particular promise: pharmaceuticals, energy and insurance. Fifty-nine percent believe technology is the most overvalued sector, with both poor pricing power and poor valuation.

Eighty-two percent expect the global economy and profits to rise over the next 12 months, with an average 10% increase in corporate earnings growth. Profits, they significantly noted, will be driven not by the rampant cost cutting of the past three years but by improvements in sales. In July, only 34% expected sales volumes to increase, whereas 50% expect that now.

Managers are also seeing net inflows into their funds and have largely become neutral on cash. However, 56% expect stock prices to rise in the single digits over the next year. Only 25% foresee double-digit growth.

Regions of the globe that fund managers expect to outperform others over the next 12 months also underscore expectations for continued growth, as these are the very regions that have historically done well in an improving global economic climate. Regions fund managers are currently partial to include Japan and emerging markets. China, too, seems to have gained in popularity, with 40% of respondents saying they see it as a source of global growth, up from 22% in September. By comparison, they expect stocks in Europe and America to underperform.

G7 Tempered Enthusiasm

However, fund managers' overall enthusiasm for the equities markets was tempered by the G7's recent decision to permit more volatility in exchange rates to lessen trade imbalances, particularly in Asia, where the dollar is kept artificially low. Three months ago, only 27% expected a more volatile foreign exchange environment. Today, 50% expect significant forex fluctuations.

The resulting unpredictability in currency rates - particularly in the dollar, which is the most overvalued major currency in the world - will also mean more unpredictability in earnings, managers said. Three months ago, only 17% of respondents expected global corporate earnings to become more volatile; that now stands at 27%. Thus, they believe companies with a domestic rather than an international focus will command a pricing premium.

"Fund managers have taken the G7 statement to heart," commented David Bowers, chief investment strategist at Merrill. "Despite recent dollar weakness, managers think the currency has further to fall, and the yen has further to rise. This, in turn, has increased expectations of both currency and earnings volatility and prompted investors to curb some of the ebullience they expressed in September."